Thursday, 5 November 2009

How Much Crappy Collateral is the Fed Warehousing?

The possibly scary answer to this question periodically gets my stomach churning. When the definitive works are written on this financial crisis, in another decade or so, I think the authors will pass judgment not so much on the overt bailout -- TARP is small potatoes, folks -- but on the "invisible bailout" that no one ever voted on, but that the Fed orchestrated behind the scenes. We can't write these definitive books yet, because the outcome of the invisible bailout isn't clear.

What put me in mind of this subject: this paper over at Zero Hedge, allegedly by a "Nathan Jerome Burchfield," that claims the Fed may have accepted crappy CMBS (commercial mortgage-backed security) collateral against loans it made. This occurred through the TALF, or the Term Asset-Backed Securities Facility. And then, after the Fed accepted this stuff as top notch collateral (AAA rated, creme de la creme), the ratings agencies -- interestingly enough -- turned around and downgraded the products.

I'll get to that oddity in a second, but first, let's pause for a moment to look at where we are in this financial mess. Ostensibly, things are going pretty well -- the troubled credit markets seem to have taken a magic calming pill -- but if you whisk back the curtain (which few Americans are inclined to do), you are treated to a crutch-like monstrosity of money-rigged supports that brings to mind that old poster "Building a Rainbow." It's hard to tell what asset prices for securities are really worth, because the Fed is swallowing them up at an astonishing rate, as long as they're bearing a AAA rating from one or two of our not-very-trustworthy credit raters. The securities (most likely generously graded) are accepted by the Fed as collateral, giving them value that they ordinarily would not have. So you give the Fed these "AAA" securities, it gives you dollar bills in exchange -- yee hah! -- then sits on your collateral.

But what's this collateral really worth? And what happens when the Fed takes collateral that then is downgraded to something less desirable -- to a rating that the Fed wouldn't have accepted in the first place?

If the Fed were smart, like say Goldman Sachs -- believe you me, it would start hoovering up more collateral, or insist on $x dollars to compensate for the downgrade. But remember: the Fed's agenda is less about protecting the taxpayer than about invisibly bailing out Wall Street. In fact, a critic might even wonder if the Fed, the credit agencies and the holders of the CMBS have in some way colluded so that the ratings hit occurs only AFTER the Fed accepts the securities. That way, the CMBS owner has already got his cash -- bye bye, so long sucker.

Certainly, at the very least, the Fed seems like the "mark" in the "market" these days. Consider: the Fed announces that, starting in July, it will accept CMBS as collateral ... meanwhile, everyone has been predicting all year that commercial real estate will be the next market to fall flat on its face. So the Fed has accumulated billions in CMBS collateral -- I think the latest figure is $6 billion -- in a sector that's prime for collapse. Dumb or really dumb?

A true-blue capitalist might argue that this is precisely the kind of sector the Fed should avoid -- let the upheaval come, the prices drop, the readjustment occur. Let the free market sort out things. But the Fed, gently intervening through its invisible bailout, helps keep asset prices artificially high.

Outraged about this example? Save some outrage. The Fed is rife with lending programs like TALF. The organization's balance sheet has become an alphabet soup of crutch-supports. And these programs have gotten pretty darn fat. Anyone recall this Yves Smith blog entry, Term Auction Facility: Confirmation of Financial Stress?, from Feb. 19, 2008 (the bold is mine)? God, seems like a lifetime ago huh?
To give a quick overview of the TAF: it was launched December 17, with two $20 billion actions, one for 28 days (the one conducted on the 17th) and a second for the 20th for 35 days. The reason for the program was that the gap between the Fed funds rate and interbank rates had become very large, suggesting that banks were reluctant to lend to each other. That was even more acute in December, since banks customarily curtail their short term lending then so they can tidy up their books for year end.

We’ve called the TAF a discount window without stigma (and in fact, the Fed implemented the TAF because banks weren’t using the discount window even when they should have). Banks can post a wide range of collateral, borrow on a non-disclosed basis, and can hold on to the cash for a while (by contrast, the discount window is overnight)

And what would you expect when you allow "a wide range of collateral"? Probably a rapidly expanding program, as banks shovel in all sorts of junk and get dollars in return. And sure enough:

The Financial Times today raises some concerns, noting that banks are indeed using the TAF to use crappy collateral for borrowing.

And note that, with no announcement I can recall, the facility has been increased to $50 billion even though the year end crunch has passed. That too is not a good sign.

So whatever happened to good 'ol TAF? By the end of June of this year, the Fed said that the value of collateral pledged through TAF was $1,570 billion (edit: actually, to be fair, only $899 billion of that was against current loans). Big, bad and bloated.

And so, the larger questions: where does all this massive intervention end? Does the Fed really think there's an easy way to just quietly and painlessly withdraw such huge levels of support? And what if that collateral turns out to be worth not very much? Who's stuck with the tab?